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The perils of a Living Wage

The
discussion surrounding a Living Wage, prompted by falling real wages over the
Great Recession, continues apace in the press. Yet what concerns me about these
efforts is not the aim, which is highly laudable, but the potential trade-off
between unemployment and underemployment.

Let me
first define my terms. Unemployment, as measured by the unemployment rate, is a
measure of the proportion of the economically active population who are
unemployed. Underemployment, however, is a measure of the number of the
employed who want more work than is currently available to them.

Falling
real wages, especially for those at the lower end of the income spectrum, is
likely to lead to an increase of the latter to the marginal benefit of the
former. That is, if the cost of workers is falling companies may be more
inclined to maintain higher staffing levels than they otherwise might but those
workers seeing their incomes fall could then want to do more work to make up
the difference. This could go some way to explaining the unusual character of
the UK`s labour market over the crisis, which has experienced a much less
severe rise in the unemployment rate than would be expected given the scale of
the economic shock.

Yet
this was not a costless gain. Real wages continue to fall because prices continued to rise despite stagnant (nominal) wage growth. Another way of
looking at it is that what people have gained in maintaining their jobs they
have paid for through sacrificing purchasing power. Not quite the jolly Christmas
message people will have been hoping for.

The question is, do we think it is better for more people to keep their jobs than
it is for those who have jobs to have their real incomes protected?

It might seem obvious at first glance – the unemployed suffer
significantly more hardship than those simply seeing their purchasing power
gradually eroded – but overall suffering is difficult to measure. Moreover, if
we were to allow wages to be completely flexible it is possible that this could
encourage firms to slash wage bills as a first recourse when facing a downturn, dramatically worsening the underemployment problem.

So some
wage stickiness, particularly nominal wage stickiness, might be considered to
be an economic benefit helping to maintain aggregate demand in a downturn and
prevent a spiral of falling demand feeding further wage cuts. Moreover,
according to Efficiency Wage
Theory,
employers themselves should be reluctant to lower wages because (net)
productivity is a function of the wage paid.

As
such, we have good reason to expect a degree of downwards wage rigidity during
a recession. In previous recessions this nominal rigidity combined with falling
prices actually meant that purchasing power increased for the employed over the
downturn:

But as
mentioned above, this came at the cost of significantly higher unemployment:

The
above chart shows the performance of the UK over the Great Recession is
something of an anomaly compared with previous downturns. This time really is different. Wages have fallen
persistently, unemployment rose less than expected but has remained well above
its pre-crisis level and inflation has also been stuck above target. As
discussed earlier, the lower unemployment rate could in fact be a function of
falling real wages. Yet we haven`t had low
unemployment, it has been and remains stubbornly high despite the hit to workers` purchasing power.

One way
of looking at this problem is that globalisation has replaced the problem of
wage rigidity with price rigidity. In a closed economy depressed demand would
cause prices to fall until the two reached a new equilibrium from which to base
a recovery. In a globalised world dominated by large multinational corporations
prices are not determined at a local level, but by global demand. If prices
cannot adjust to a level consistent with full employment then wages must carry
the burden.

What do
wage rigidities do in this situation? Look again at the unemployment rate chart
and we may be seeing one consequence of them. The unemployment rate has
remained largely constant since the middle of 2009. One explanation for this
could be that firms were unable to sufficiently adjust their input costs,
including labour costs, meaning there has been more slack in the labour market
than there otherwise would have been.

Yes, under
a flexible wage scenario wages would have fallen more sharply. But if more
people had been employed it is possible that the recovery would have set in
earlier too. With the labour market tightening wages would have been pushed up
and productivity improved.

Of course,
there are significant potential downsides to completely flexible wages. As
Miles Kimball explained in a recent Quartz article:

“The
only way a bottom-of-the-heap, dead-end job will ever be worth something to a
worker is if there is a something worse than a bottom-of-the-heap, dead-end
job. In Efficiency Wage Theory, that something worse is being unemployed. To
make workers care about bottom-of-the-heap, dead-end jobs, employers have to
keep raising their wages above what other firms are offering until workers are
expensive enough that there is substantial unemployment—enough unemployment
that being unemployed is worse than having one of those bottom-of-the-heap,
dead-end jobs. For the worker, Efficiency Wage Theory is bittersweet.”

Wage
falls could make relying on state benefits preferable to working in these
“bottom-of-the-heap, dead-end jobs”. As such in order to provide an equilibrium
state consistent with full employment benefits would have to be withdrawn and
unemployment made even less tolerable that it already is. We can see some of
this thinking behind the Coalition`s workfare scheme, for example.

From a
moral standpoint making unemployed life utterly intolerable is difficult to
defend, especially if you believe that luck plays important
roles in people`s career outcomes. A Living Wage, or much higher minimum wage,
presents one solution by setting wage levels high enough to maintain incentives
for the unemployed to seek work but if it comes at the cost of higher
unemployment in a downturn it may be of scant comfort to those forced out of their jobs.

I think
the problem here is being misdiagnosed. Low paid, “bottom-of-the-heap, dead-end
jobs” are a function of the lack of low-skilled workers` bargaining power. If
we could empower both the employed and the unemployed, say through a basic
income model, those jobs that are necessary
would have to adjust their wage offers to compensate people for the nature
of the work. A basic income would also allow for a much greater degree of wage
flexibility, as workers would be less resistant to accepting pay cuts in a
downturn and more forceful in demanding compensation during a boom, even as it provides a backstop to aggregate demand (preventing a downwards wage/demand spiral).

Ultimately
there will always be trade-offs. But we should not as a society become blinded
to human suffering in the name of economic efficiency.

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Comments

1. I'm not sure the Aggregate Demand (Not Enough Of It) problem can easily be solved by setting a bottom level of income (whether it is the sum of all benefits an unemployed recipient is entitled to, or a Living Wage). As you point out, the market clearing price of labour fluctuates as the economic climate changes. A fixed income floor that would always be below market clearing wage levels would probably make life for those who had no choice but to live on it indeed "utterly intolerable".
It's very hard (and maybe impossible) to fix two problems - insufficient aggregate demand, and providing households with an income on which they can live a decent life, whether or not they are in employment - with one single measure. It might be better to use the Living Wage/benefits level mechanism to manage the latter, and to resort to other tools to address temporary aggregate demand problems (e.g. helicopter money).

2. I disagree :-) But maybe I didn't explain my point well enough. To be blunt: no, neither rubbish collectors, nor carers for the elderly or the infirm are necessary in an absolute way. If my family is starving, and I have to only enough money to either pay someone for food, or pay someone to have my rubbish collected, I am sure you can guess where my money will go. When resources are scarce (which, pretty much they are), I think there are always trade-offs to be struck, and that does include rubbish collection and care for the elderly as much as brain surgeons and economists.
Of course, if in wage negotiations one party (usually the supplier of labour) lacks bargaining power, the division of the economic surplus of a successful transaction is likely to flow to the other party (usually the employer). But there has to be an economic surplus, and the part of it that goes to the employer needs to be above zero - otherwise the job does, really, become "unnecessary".

1. It is certainly true that Miles would not, and has never, argued that the lives of the unemployed should be intolerable so I apologise if it came across that way. My point is that Efficiency Wage Theory here might clash with Keynesian fiscal stabilisers - that is the market clearing labour price might be so low during a recession that it might have a large negative impact on the aggregate demand outlook. If people believe that low wages will persist they will adjust their expectations - indeed that is one of the problems that the UK, for example, is currently facing. In this light the only way to drop benefit levels below wages in severe downturns would be to make unemployment effectively intolerable - though that would not apply under "normal" conditions.

2. I disagree. Are the people who collect the rubbish not "necessary"? Those caring for the elderly or the infirm? And are they well paid? I think we confuse a glut of available labour with a lack of necessity. Low wages in these jobs likely a consequence of the former not the latter. Low-skilled workers need *some* bargaining power.

Posted by Koen Smets on Dec 18th 2013 9:41

Interesting article. I agree with you that (nominal) wage rigidities have significant benefits, which probably outweigh their downsides - both economically and morally.

However, while you conclude by saying "Ultimately there will always be trade-offs", it seems to me that in the paragraphs just above there are some absolutist viewpoints:

1. You say "From a moral standpoint making unemployed life utterly intolerable is difficult to defend" - I don't think anyone has suggested this (certainly not Miles Kimball in the article you quote, so this comes across as a bit of a straw man. I think the point is that there has to be a clear distinction between unemployment and employment for the employment option to be _relatively_ more attractive than the unemployment option. This does not require the latter to be "utterly intolerable" - in theory the distinction could exist with a living wage at any level, provided the income differential is large enough. The key is the trade-off that people at that level of income need to make: is the marginal improvement in situation worth the marginal effort?

2. In the penultimate paragraph you refer to jobs that are /necessary/ - I am not sure there are many, or indeed any, such jobs. (There are certainly jobs that are *unnecessary* but that is a different affair :-)) How would the term 'necessary' be defined in the first place? At the very least, if such a job were not done, the consequences should be profoundly bad. Looking at the lowest-paid jobs (and indeed at many higher-paid jobs) I struggle to find even one that qualifies - it's too easy to look at cities and countries that are less middle-class than middle-England where they do not exist, without apparent dramatic consequences. Those jobs that really are necessary, unsurprisingly, already tend to be relatively well paid. So here too, it's a matter of trade-off: the more necessary a job is, the higher its wage relative to other jobs. That principle would continue to apply even with a Living Wage.

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